Financial shock

Primary reference(s)

ECB, 2013. Financial Shocks and the Macroeconomy: Heterogeneity and Non-Linearities. European Central Bank (ECB), Occasional Paper Series No. 143. Accessed 12 September 2020.

Additional scientific description

The term ‘financial shock’ generally refers to a disruptive event in the financial system, which manifests in the sudden re-pricing of assets (often in combination with a severe deterioration of economic conditions). Financial shocks are difficult to predict but tend to be more likely when borrowers are vulnerable, such as when they have taken on excessive risk relative to their repayment capacity (e.g. highly-leveraged firms that have both uncertain future profits and low liquidity) (Peersman, 2015).

Financial shocks may be triggered by different sources of risk, that can be either inside or outside the financial system, and are often amplified by adverse macro-financial feedback effects, such as when a deterioration in economic conditions weakens the solvency of financial institutions and markets, which in turn results in tighter financial conditions for firms and households (Ong and Jobst, 2013). A significant economic slowdown could lead to rising business insolvencies, higher unemployment, and constrained public investment. They can morph into financial crises if a sharp decline in asset prices causes consumers and businesses to default on their loans, and financial institutions become unable to access liquidity – either in terms of cash or assets which are easily convertible into cash (Moretti et al., 2020).

For example, the collapse of the U.S. sub-prime mortgage market, prior to the 2007–2009 Global Financial Crisis, was largely driven by excessive leverage of borrowers, an overheated housing market, and insufficient transparency when banks re-packed and combined mortgage loans into new financial instruments, through what is referred to as ‘securitization’ (Jobst, 2008). Recent currency and/or sovereign debt crises also illustrate that unsustainable external imbalances, such as a deteriorating current account (which reflects cross-border economic activities) and rising foreign currency borrowing by public or private sector organisations (if suddenly unwound), can amplify and/or cause fragilities in the financial system. Examples include the cases of the 1997 Asian financial crisis and the 2007–2009 Global Financial Crisis (Claessens et al., 2014).

Metrics and numeric limits

Measures linked to financial shocks typically focus on aspects of financial stability, due to the inherent difficulty in predicting the occurrence of financial shocks (IMF, 2020a). Examples of these measures include:

Financial sector: financial soundness indicators (solvency, liquidity, asset quality) of banks and non-bank financial institutions (insurance companies, investment funds, and other asset managers), default risk (via credit ratings or credit default swap spreads).

Financial markets: equity prices, corporate bond spreads (as measure of default risk), market liquidity/volatility, house prices (indicate bubbles/crashes).

Other sectors: measures of corporate financial risk (e.g. corporate debt), households (e.g. household debt), and governments (e.g. public debt), as well as real economic activity (e.g. GDP growth, interest rates, inflation) and external ratios (e.g. balance of payments, exchange rates).

Examples of drivers, outcomes and risk management

The health and functioning of a country’s financial sector has far-reaching implications for its own and other economies. Prudential regulators and supervisors play a central role in safeguarding the capacity of the financial system – its intermediaries, markets and infrastructures – to provide deposit, credit, and other financial services to households, firms, and governments (OECD, 2010).

Designing policies that align private incentives with the public interest to facilitate market discipline and limit excessive risktaking is challenging. In some cases, a financial institution and/or market might be considered too-big-to-fail (TBTF), because their insolvency and failure could cause massive disruptions to the functioning of the financial system, resulting in a significant tightening of financial conditions and a contraction of economic activity. This situation creates an expectation that they would be bailed out by the government, via direct financial support measures, during times of stress. Safety nets, such as deposit insurance (guaranteeing bank depositors access to their money even if a bank fails), play an important role as shock absorbers, helping to maintain the functioning of the financial system during times of stress.

At the national level, regulated financial institutions are subject to both microprudential and macroprudential oversight:

Microprudential supervision focuses on the safety and soundness of individual financial institutions, such as banks, insurance companies, and investment funds. Supervisors complete regular on- and off-site inspections and reviews to ensure that these financial institutions are well-managed and have enough capital to absorb the impact of adverse shocks (such as a recession).

Macroprudential surveillance elevates this concept of financial supervision to a system-wide perspective, by focusing common vulnerabilities across all or several institutions. Macroprudential measures to mitigate risk, such as additional capital requirements, are not specific to individual firms but apply uniformly across all relevant institutions.

International institutions facilitate cross-border coordination across supervisors and regulators through agreements on common standards and peer reviews (e.g. Bank for International Settlements, Financial Stability Board) while others focus on multilateral surveillance and direct engagement with countries, often via capacity building and technical assistance (e.g. International Monetary Fund, World Bank) (IMF, 2020a; World Bank, 2020). The Financial Sector Assessment Program (FSAP) represents a comprehensive and in-depth analysis of a country’s financial sector. FSAP assessments are the joint responsibility of the IMF and World Bank in “developing economies and emerging markets”, and of the International Monetary Fund alone in “advanced economies” (IMF, 2019).